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Is there anything the US Federal Reserve WON'T do?

Interest-Rates / Credit Crisis 2008 Apr 11, 2008 - 09:38 AM GMT

By: Money_and_Markets


Best Financial Markets Analysis ArticleThat's the question I'm asking myself here as I watch it go further and further down the "extreme activism" road.

As I've pointed out, it's not just the Fed, either. Congress and the Bush administration are stepping up their plans to intervene and support the housing and mortgage markets, too.

I'm half-expecting to wake up one day and read that the government has decided to buy and then bulldoze every foreclosed house in the country to rid us of the inventory overhang.

Seriously, though, I'm fine with some of the things being done. They make sense.

But ...

Other measures are a clear violation of the free market principles this country was founded on. And some may not even be legal!

Not to keep flogging the Wall Street Journal or anything, but there was another great story this week called "Fed Weighs Its Options in Easing Crunch." It said the Treasury Department might sell excess debt — beyond what it needs to keep the government running — and deposit the money at the Fed. The Fed would take those funds and buy Treasuries in the open market.

The Fed's aim? To replenish its rapidly dwindling pile of top-quality debt securities. It's shrinking because the Fed has opened the door to just about any old crummy paper Wall Street and the nation's top banks can throw its way (More on this in a minute).

Federal Reserve Chairman Ben Bernanke is confident that government regulations and incentives will compel Wall Street participants to be more honest.
Federal Reserve Chairman Ben Bernanke is confident that government regulations and incentives will compel Wall Street participants to be more honest.

The Journal also said the Fed is considering selling its own debt securities, then using the money to buy assets or make loans.

Some on Wall Street want the Fed to go even further — actually buying mortgage-backed securities outright as opposed to temporarily taking them off the hands of primary dealers and banks.

But if you can believe it, the Fed might not even stop there. There's the possibility the Fed could go the route of the Bank of Japan in a real emergency. Specifically, it could print vast amounts of money, drive the federal funds rate to near-zero percent, and go hog-wild buying securities or making loans — a process called "quantitative easing" in econo-speak.

The fact these measures are even being discussed shows just how serious this credit crisis is.

And That's Just the Half of It!

Take the Term Securities Lending Facility, or TSLF. That's the series of auctions at which the Fed swaps its Treasuries for other debt securities.

The auctions were initially going to be focused on things like residential mortgage backed securities. The idea was that investors were irrationally dumping everything, including top-quality debt backed by prime-credit, conventional mortgages. So the Fed "had" to step in and help liquefy things to enable mainstream borrowers to purchase homes.

Sounds good, right? But since then, the TSLF plan has morphed into something else. It appears that after some lobbying and coaxing from self-interested parties, the Fed decided to expand the eligible collateral to include commercial mortgage backed securities (CMBS).

What do CMBS have to do with the housing crisis? Nothing. But Wall Street is taking a pounding on the value of those securities — which they made billions of dollars bundling and selling over the past few years, by the way. So the call for relief from the Fed went out, and voila, the Fed obliged.

But that's not all. A Bloomberg story this week, citing analysts at Morgan Stanley, chronicled how Wall Street firms are apparently starting to bundle corporate buyout loans into securities for the express purpose of turning around and using those securities to borrow from the Fed!

Specifically, Morgan Stanley noted that at least one Collateralized Loan Obligation (a bundle of loans, including those used to fund takeovers) appeared to have been structured so that it could be used as collateral at the Fed's Primary Dealer Credit Facility. The PDCF was just rolled out to allow non-bank institutions to access Fed liquidity — something that hasn't happened since the Great Depression.

What do these new moves mean? In plain English, the Fed has gone from ostensibly trying to help poor, little old ladies on Main Street who are facing foreclosure ... to greasing the credit wheels for developers who want to build high-rise office properties and Wall Street dealmakers who spend their days plotting the takeover and restructuring of America's corporations.

And don't even get me started on a provision in the Senate's latest housing and mortgage reform bill. It would allow corporate home builders to take losses they've racked up in recent times and use them to offset profits earned up to four years ago.

In other words, they'd be able to qualify for potentially billions of dollars in refunds of taxes they paid during the bubble days!

After intense lobbying efforts, the National Association of Home Builders was recently rewarded as Congress rolled out a proposal designed to bailout builders.
After intense lobbying efforts, the National Association of Home Builders was recently rewarded as Congress rolled out a proposal designed to bailout builders.

Why did this provision find its way into the Senate bill? Does it make good policy? The line from the home building lobby is that this is good for the housing market and will save jobs.

But I don't believe it — the last thing we need is for builders to continue operating on taxpayer-funded life support. We need to cull the weak from the herd. That will help further reduce construction activity, and get inventories under control — the only recipe for stabilizing prices in the long run.

One more sidebar here: The National Association of Home Builders announced in mid-February that it would "cease all approvals and disbursements of BUILD-PAC contributions to federal congressional candidates and their PACs until further notice."

I'm sure it's pure coincidence that this builder bailout proposal was rolled out just a few weeks after the home building lobby said it will stop funneling reelection money to Congress.

Where Does It All End?

Look, I get that we're in a crisis here. The International Monetary Fund — a group not exactly known for exaggeration and hyperbolic predictions — just released a report pegging the total cost of the credit crisis at an eye-popping $945 billion! Said Jaime Caruana, head of the IMF's Monetary and Capital Markets Department:

"Financial markets remain under considerable stress because of a combination of three factors ... First, the balance sheets of financial institutions have weakened; second, the deleveraging process continues and asset prices continue to fall; and, finally, the macroeconomic environment is more challenging because of the weakening global growth."

So maybe this is just a case of desperate times calling for desperate measures. But don't we have to stand up and ask: "Where does it all end?" How far are we going to allow the Fed to go to subsidize Wall Street? What the heck happened to free markets? Capitalism?

Maybe investors aren't being irrational. Maybe they're shunning all the paper Wall Street is burdened with because they're making a perfectly rational investment decision: Namely, they've decided it's not worth much.

They can see house prices falling ... commercial real estate values starting to decline ... the economy slumping into recession ... and the multi-year credit binge we've been on coming to an end. So they're not buying crummy, complicated debt securities anymore. Maybe, just maybe, the Fed shouldn't be standing in the way of the crunching of all those debts.

Legendary former Chairman of the Fed Paul Volcker warned in a speech earlier this week that the Federal Reserve is at the very edge of its lawful powers.
Legendary former Chairman of the Fed Paul Volcker warned in a speech earlier this week that the Federal Reserve is at the very edge of its lawful powers.

I'm not the only one that's concerned about what is going on here, either. The legendary former Chairman of the Fed itself — Paul Volcker — gave a speech this week warning about what the Fed is doing, as well as its consequences. A key quote:

"The Federal Reserve has judged it necessary to take actions that extend to the very edge of its lawful and implied powers, transcending in the process certain long-embedded central banking principles and practices."

And he took no prisoners when critiquing the Bear Stearns bailout, saying:

"What appears to be in substance a direct transfer of mortgage and mortgage-backed securities of questionable pedigree from an investment bank to the Federal Reserve seems to test the time-honored central bank mantra in time of crisis: lend freely at high rates against good collateral; test it to the point of no return."

Moreover, it's not like what the Fed is doing is consequence-free ...

Dangerous Precedents Are Being Set ...

Look at what has happened to the dollar ... to oil prices ... to food prices and so on. There are fundamental economic reasons for the moves we're seeing in commodities. But those moves are being turbocharged by the easy-money policies of the Fed.

Indeed, one measure of U.S. money supply — M2 — surged at a 17.9% annualized rate in February. I have a Bloomberg chart that goes all the way back to 1959 on this indicator. It has only risen this quickly a handful of times in U.S. history.

The Fed is clearly playing a perilous game by slashing rates and shifting the presses into overdrive at a time when inflation pressures are high, the dollar is weak, and commodities are through the roof.

So Wall Street may appreciate what the Fed is doing. They may like the fact that they're on the receiving end of all this Fed largesse. But the rest of us are taking a real hit to our standard of living as a result ... and we're setting some dangerous precedents for the future.

Until next time,

By Mike Larson

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